Investment 101

If you knew nothing about investing and only had three minutes to brush up, this article is a very good place to start.

RISK & RETURN

The parameters governing any investment decision are that of risk and return. A low investment risk usually means a lower investment return. As investment risk increases, an investor justifies this additional risk with the expectation of a greater return.

DIVERSIFICATION

The adage, “don’t put all your eggs in one basket” reflects the wisdom of diversification. It is the simple principle of spreading investments over a number of investment types or classes and again within each investment class. This lessens the possible losses that could arise if one class of investment performs poorly and all of one’s funds were invested in that class or individual investment.

ASSET CLASSES

Asset classes are defined as investments that behave similarly, exhibit similar characteristics and are subject to the same laws and regulations.

Conversely, cash, domestic fixed Interest and international fixed interest are considered defensive asset classes as they typically provide lower expected returns and risk (i.e. more stability in expected returns).

Investing within an asset class can be undertaken via ‘passive’ or ‘active’ investment management, where active management encompasses a broad array of investment styles.

Passive Investment Management

Passive investing is an investment style that targets a benchmark index. Passive investing is often associated with a ‘set and forget’ investment strategy and is popular with ‘hands-off’ and non-active investors.

An example of a passive investment strategy is an investor who wants their investment portfolio (or a portion of it) to reliably receive the same return as the S&P/ASX 200 index. To achieve this an investor would need to invest in each of those 200 companies, in appropriate weightings. Or more realistically, they would invest in an index managed fund or exchange traded fund (ETF) which would make that spread of investments within their fund on the investors behalf, for a small fee.

Pros and Cons

Passive investing provides broad diversification (depending on the index it tracks) at low investment management costs. A downside of this investment style is the inability for a portfolio to outperform its chosen benchmark.

ACTIVE INVESTMENT MANAGEMENT

Active management is a style of investing that seeks to generate additional returns above a benchmark index or targets a different investment mandate. When an investor makes an investment decision based on a conviction or belief with a view to profit beyond normal market movements or achieve a specific investment goal, they are ‘actively managing’ their investment.

The principle behind active management is that skilled investors should be able to outperform their chosen benchmark indices. Professional investors, like fund managers, do this for a living with the aim of providing their investors a net benefit once investment fees are deducted.

Should an investor attain a net benefit (after fees) above the benchmark then they have generated what professional investors call ‘alpha’. Their portfolio return represents the sum of the benchmark market component (Beta) and additional value added through active management (alpha).

Pros and Cons

Active management, if engaged through an investment professional can be expensive with no guarantee of performance. The key advantage of this investment approach is the ability to generate returns above a benchmark index or invest in a manner that targets an investment goal completely removed from that of an index.

INVESTMENT TIME FRAME

Your investment time frame refers to the length of time you intend to maintain your investment portfolio. This plays a significant role in influencing the selection of investments.

For short to medium term investment time frames, there is insufficient time for long term market trends to override or ‘iron out’ short term volatility cycles which can significantly affect your return. If you need to sell your investment at a specific time you could find yourself selling when the investment is at the bottom of one of those cycles.

Warren Buffett, in his most recent annual report, tells us that it doesn’t matter how good the underlying investment is, if your investment time frame limits the time the investment can be held; then market volatility, not the quality of the investment strategy, will dictate your returns.

“For those investors who plan to sell within a year or two after their purchase, I can offer no assurances, whatever the entry price. Movements of the general stock market during such abbreviated periods will likely be far more important in determining your results than the concomitant change in the intrinsic value of your shares

— Warren Buffett

Real Life Example

Take for example an individual in their early 30’s, lets call them Phoebe. Phoebe accumulates wealth in both a personal investment account and a mandated superannuation fund. Phoebe plans on utilising her personally held investment funds within the next two years to fund the purchase of her first home. Conversely, Phoebe's superannuation investments will, most likely, only become accessible when she is in her 60’s, in over 30 years time.

These two investment accounts require very different investment strategies, irrespective of the investors tolerance for investment risk;

The personally held investments require greater capital security than the superannuation fund investments as these personal funds need to be realised within a set time frame. This means the investor cannot afford to wait for the investment cycle to rise again before selling if there is a downturn in the investment cycle within the next two years; Whereas

The superannuation funds, which have a long term investment time frame, can pass through a number of cycles and benefit from the long term positive market trend. Therefore they can be invested in a higher proportion of growth assets than Phoebe's personal investment account.

HOW TO GET STARTED

Investing isn't difficult and many people are overwhelmed by the perception of investment complexity. Technology has provided us all with a great set of tools to get started simply and cost effectively. All of us have bank accounts and each of the major banks provides a consumer focussed brokerage account. These are simple to establish and typically link to your transaction account making cash management very straightforward. Once opened you just need to start investing and preferably, regularly allot savings into your investment portfolio. If you're starting small then consider investments that provide efficient diversification of investment capital, without triggering lots of brokerage costs. Some investments to consider which simply diversify your investment exposure, without the need for portfolio scale, are as follows;

It can take time to become accustomed to investing. As you begin to see the benefits accrue over time, especially once you ride out a full business cycle, your confidence and investment wealth will grow in time. It is important to remain un-emotional about short term (less than two year) fluctuations in capital.

Once your portfolio generates scale, you can start becoming more targeted with your investment strategy, structure and philosophy. Effective planning in these areas can generate significant value for your circumstances. If you lack the time or expertise but want to more assertively manage your investments, then consider speaking to a professional.